Economic Analysis for Business

1. Economic Analysis for Business Chapter 11 The Keynesian Revolution and Say’s Law

2. John Stuart Mill in 1844 “The utility of a large government expenditure, for the purpose of encouraging industry, is no longer maintained....” “It is no longer supposed that you benefit the producer by taking his money, provided you give it to him again in exchange for his goods.”

3. Mill was defending Say’s Law • high levels of public spending do not encourage industry • spending does not of itself create growth and employment • you cannot make an economy prosper through expenditure but only through value adding production • demand does not drive an economy forward, nor does demand deficiency cause recessions

4. Wilfully and deliberately destroyed by Keynes The Keynesian Revolution, and therefore the origins of virtually all macroeconomic theory today, can only be understood in relation to Keynes’s coming across Malthus’s economic writings in 1932 In the General Theory Keynes is very clear about what he has learned from reading Malthus

5. From the General Theory “Malthus … had vehemently opposed Ricardo’s doctrine that it was impossible for effective demand to be deficient; but vainly. For, since Malthus was unable to explain clearly(apart from an appeal to the facts of common observation) how and why effective demand could be deficientor excessive, he failed to furnish an alternative construction; and Ricardo conquered England as completely as the Holy Inquisition conquered Spain….”

6. Keynes continues “… The great puzzle of Effective Demand with which Malthus had wrestledvanished from the economic literature.”

7. The General Theory once again “The celebrated optimism of traditional economic theory is to be traced, I think, to their having neglected to take account of the drag on prosperity which can be exercised by an insufficiency of effective demand.”

8. Say’s Law and unemployment – according to Keynes “Say’s law … is equivalent to the proposition that there is no obstacle to full employment.”

9. Say’s Law can only be understood as a series of related propositions Say’s Law is not properly contained in a single statement but consists of a series of related propositions Not called Say’s Law during classical times: the phrase is twentieth century American from the 1920s Most commonly referred to during classical times as the Théorie des Débouchés or in English, the Law of Markets

10. Proposition 1 Proposition 1: Recessions are never due to demand deficiency. An economy can never produce more than its members would be willing or able to buy. High levels of saving do not cause recessions.

11. Friedrich Hayek 1931 “The assertion that saving renders the purchasing power of the consumer insufficient to take up the volume of current production … is almost as old as the science of political economy itself…. The idea recurs in those writings of … Malthus which gave rise to the celebrated Théorie des Débouchés of … J.B. Say. In spite of many attempts to refute it, it permeates the main doctrines of socialist economics…. Fortunately it has not succeeded as yet in depriving saving of its general respectability.”

12. Proposition 2 Proposition 2: Demand is constituted by supply.

13. Henry Clay 1916 “It is only because our exchanges are made through money that we have any difficulty in perceiving that an increase in supply is (not ‘causes’) an increase in demand…. What is divided among the members of society is the goods and services produced to satisfy its wants; and the same goods and services are both Supply and Demand.”

14. Proposition 3 Proposition 3: Purchase and sale is the conversion of one’s own goods into money and then the re-conversion of the money one has received back into other goods. Money is intrinsic to the processes involved.

15. Jean-Baptiste Say 1821 “Should a tradesman say, ‘I do not want other products for my woollens, I want money,’ there could be little difficulty in convincing him that his customers could not pay him in money, without having first procured it by the sale of some other commodities of their own.… Almost all produce is in the first instance exchanged for money, before it is ultimately converted into other produce.”

16. Proposition 4 Proposition 4: Recessions are common and result in high levels of involuntary unemployment.

17. Robert Torrens 1821 “So long as the proportion is preserved, every article which the industrious classes have the will and power to produce, will find a ready and profitable vend. No conceivable increase of production can lead to an overstocking of the market…. Increased production will create a proportionally increased demand [sound familiar?] ….

18. Proposition 5 Proposition 5: Recessions are due to structural problems. Recessions occur where the structure of supply does not match the structure of demand.

19. Torrens in 1821 continues “… This happy and prosperous state of things is immediately interrupted when the proportions in which commodities are produced are such as to disturb the equality between effectual demand and supply…. Then gluts and regorgements are experienced.”

20. Haberler 1937 “An expansion or contraction may be interrupted on the one hand by an accident…or it may on the other hand itself give rise to maladjustments in the economic system…. Most cycle theorists have tried to prove that the second type of restraining force is all-important.”

21. Proposition 6 Proposition 6: Overproduction of individual goods can lead to a general downturn in an economy. The transmission mechanism is from a reduction in earnings in some sectors to a fall in demand in other sectors and therefore to a wholesale downturn in activity.

22. Walter Bagehot 1873 “No single large industry can be depressed without injury to other industries; still less can any great group of industries. If industry A fail and is in difficulty, industries B, and C, and D, which used to sell to it, will not be able to sell and in future they will stand idle till industry A recovers.”

23. Proposition 7 Proposition 7: Monetary factors, most notably a contraction of credit, can also be and often are an important cause of recession. Even where monetary instability has not been the originating cause of recession, monetary factors will often deepen a recession brought on for other reasons.

24. Becker and Baumol 1952 “Indeed, in reading [Mill on the problems caused by monetary problems] one is led to wonder why so much of the subsequent literature (this paper included) had to be written at all.”

25. Proposition 8 Proposition 8: Because recessions are not due to a failure of demand, practical solutions to recession do not encompass increased levels of public spending. Such expenditure is merely a palliative rather than a cure.

26. Mill again 1844 “The utility of a large government expenditure, for the purpose of encouraging industry, is no longer maintained.... It is no longer supposed that you benefit the producer by taking his money, provided you give it to him again in exchange for his goods.”

27. Ricardo in 1820 – the best short statement of Say’s Law ever made “Men err in their productions, there is no deficiency of demand.”

28. What if policy followed Ricardo no ambiguity, no uncertainty about what “supply creates its own demand” does or does not mean when you see recession in the real world, cannot be understood as a consequence of too little demand but has been caused by a derangement of some sort within the market process policy makers would be constrained from increasing levels of spending to the extent we have recently witnessed but would understand more fully the kinds of policies needed to get markets back on track RMIT University

29. Say’s Law and the Keynesian Revolution • macroeconomics replaced the classical theory of the cycle in the 1930s and has remained Keynesian to this day • Keynesian policy has not had a single success but has recorded many failures to which yet another can now be added